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The UK’s Fiscal Recovery Has Begun

uk finance
Written by Robert Lee

The Chancellor’s Spending Review – eye-watering headline numbers and apocalyptic media coverage notwithstanding – marks the start of the UK’s return to fiscal sustainability. Controversial hard choices were made, but self-defeating “austerity” avoided. High deficits and debt can be sensibly reduced over time through restraint on current government spending, productive public sector investment and fiscal reform. This is the path we are now on.

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The UK’s 20/21 fiscal deficit is now forecast by the OBR (Office of Budget Responsibility) to be £394bn. At 19% of GDP this is almost double the previous peacetime deficit high in 2009/10. Treasury hardliners and Tory fiscal hawks are having the vapours. It is right to emphasise the long term dangers of debt and deficits on this scale, but to respond with severe spending cuts and swingeing tax rises would be entirely self-defeating. Some respected commentators have taken to issuing bloodcurdling warnings of future fiscal and economic crises that seem to lack any historical or international context.

The UK’s Current Fiscal Position in an Historical and International Context

The UK ended WWII with a massive government debt to GDP ratio of 250%, but nevertheless then embarked on a multi-decade economic recovery,    interspersed with only moderate recessions. The debt ratio gradually reverted to historical norms.  At the end of this fiscal year the debt ratio will be around 105% – much less than half of that wartime high. In more recent times UK governments have twice substantially reduced the debt ratio in a relatively short period. The Thatcher government cut the debt ratio from roughly 45% to 25% between 1982 and 1992, while the debt ratio fell under the Blair government from 40% to 26% in the six years to 2001. The OBR estimate that even in their (arguably too pessimistic) central scenario, spending cuts and/or tax rises amounting to only 1% of GDP would stabilise the debt ratio.

For technical reasons related to Bank of England (BOE) operations (see Appendix) even the headline ratio of 105% is overstated. Excluding the impact of these operations gives an “underlying debt” ratio estimated by the OBR to be 91.9% at the end of 20/21. On the OBR’s central forecast, given current policy, underlying debt rises further to reach 97.5% by 2025/26. These are uncomfortable figures but in an era of exceptionally low interest rates hardly the fiscal apocalypse painted by some critics. The UK’s debt ratio is markedly lower than a number of large economies, including Japan, the USA, France, Italy, and Spain. The UK also has an unusually long average debt maturity profile. UK economic policymaking has by international comparison been creative, nimble and well coordinated (confirmed by the IMF no less). Having a government with a large parliamentary majority – albeit getting fractious with lockdown fever – provides relative stability. Neither the US or EU can currently demonstrate such political stability or economic policy coordination.

So the historical context shows that our current fiscal problems, although serious, are hardly insurmountable. The international context shows that we are still relatively well placed. Nevertheless, can the government demonstrate it has the capacity and ideas to turn the fiscal picture around before a genuine loss of fiscal credibility does occur? I believe the Spending Review shows it can.

The Spending Review

The Spending Review does not cover the government’s taxation plans, so a full assessment of fiscal policy must await next year’s March Budget. However, the following elements of the Spending Review, and the accompanying OBR analysis, persuade me that the government is getting a grip on the Covid-induced explosion in debt and deficits:

  • All Covid-related income support measures – the furlough scheme, the universal credit uplift, business rates holiday and others – end in March next year. Furthermore, the Chancellor showed that the government is prepared to make unpopular or controversial choices to control non-Covid spending. The two headline measures are a partial public sector pay freeze in 21/22 and a reduction in the foreign aid budget from 0.7% of GDP to 0.5% “until financial conditions improve”. Although given less publicity the Chancellor also eased restrictions on Council Tax rises, and announced that from 2030 investments and pensions linked to the Retail Price Index (RPI) will instead track the CPIH index, which typically rises by 1% less p.a than the RPI. Over the very long term this simple technical change will provide large savings to government.
  • Contrary to the public image portrayed by some in the media the government has not embarked on a wild spending spree. No doubt the pandemic has engendered some wasteful Covid-related spending, but the critics see it as a wider issue. However, in the OBR’s central scenario government spending excluding Covid-spending (which is assumed to end during the 21/22 fiscal year) only rises from 40% of GDP in 2019/20 to 43% in 20/21 and 21/22 before falling to 42% of GDP in the following three years. Compared to the March Budget the Spending Review actually cuts annual current departmental spending from 21/22 onwards by nearly £12bn (this includes the impact of the public sector pay freeze and cut in the foreign aid budget).
  • The forecast rise in underlying public spending is mainly due to a long overdue rise in capital spending. Public Sector Net Investment (that is net of depreciation) is set to rise by 23% in 20/21, 20% in 21/22, 9% in 22/23 and then 2.5% in each of the following two years. This is the biggest public sector investment programme for 40 years. With the government able to issue 10 year bonds at a yield of around 0.30% any capital project with a reasonable rate of return will more than pay for itself. Such capital spending gives a short term boost to the economy and lifts the long term growth potential of the economy. The UK’s economic recovery from the 2008/9 financial crisis was weaker than it need have been because George Osborne mistakenly slashed capital spending while maintaining growth in current spending. This time the policy response to economic downturn has got the balance right.
  • The OBR’s November 2020 Fiscal and Economic Outlook is an extremely detailed and highly professional document. However, the OBR does have a record of erring on the side of economic and fiscal pessimism. They seem to be making the same error again – indeed the recovery from the end of Q2 until October was markedly stronger than the OBR March forecast. The OBR November central scenario forecast only sees economic output reaching pre-Covid levels by the end of 2022, but this forecast was made before the latest Covid vaccine breakthroughs were announced. The OBR’s upside scenario assumptions – that the national lockdown substantially reduces the infection rate, the testing regime and tiered lockdown system subsequently keep the infection rate in check, and an effective vaccine becomes widely available in the spring – now seem very credible. In this case the OBR sees output returning to pre-Covid levels by the end of 2021, and the underlying debt ratio returning to the 90% level at the end of the forecast period without requiring any further spending cuts or tax increases. In the OBR’s words “the medium term impact of the pandemic in this scenario is negligible”. This is the same document that a respected City commentator, in a column headed “Britain is facing Ruin”, hysterically described as “easily the most terrifying official economic assessment from a developed nation I have ever read”! Financial markets don’t believe him, as the FTSE is up 15% in the last two weeks and some “value” stocks heavily linked to the domestic economy up by much more than that.
  • The OBR may in any case be underestimating the potential “pent up demand” in the economy from both business and consumers. The household savings rate rose to an astonishing 28% in Q2, compared to the normal range between 5-10%. Corporate savings have also risen as investment plans have been held back. UK M4 money supply rose by 12% in the year to September, reflecting a large rise in household and company money balances held in the banking sector. The boost to confidence as “normality” returns may see business investment and consumer demand rise more strongly than anticipated by the OBR, aided by powerful stimulus from public sector infrastructure spending.

Conclusion

I believe the probabilities strongly favour the OBR’s upside scenario, which is  in line with the view put forward in my last article (“The Covid doomsters are wrong: the UK is heading for recovery”). Apart from setbacks on the Covid front what are the other key threats to this scenario? This piece is written before knowing the final outcome of the EU/UK trade talks. The OBR estimates a “no deal” outcome would induce a medium term hit to the economy of around 1.5%. I agree with BfB’s analysis that the OBR is far too pessimistic on this score, but even on their estimate this is a trivial difference in the context of recent huge Covid-related disruptions to the economy.

The biggest threat would be a premature attempt to tackle the rising debt levels with damaging tax increases or more spending in the March Budget. There will be forces in the Treasury and elsewhere pushing the Chancellor in this direction. The Chancellor should instead take a leaf out of President Ronald Reagan’s book. In Reagan’s first term (1981-84) massive tax cuts and a huge defence build-up created large (at least they seemed so at the time!) budget deficits. He was unable to cut non-defence spending, but adamantly opposed to reversing course on taxes. He was instead persuaded to embark on a serious tax reform programme, slashing exemptions, allowances and deductions to both company tax and income tax. The “Great Communicator” was able to sell this complex package – the Tax Reform Act 1986 – to Congress and the public. This Act made major reductions in tax rates but simultaneously raised significantly more revenue, thus enabling Reagan to close the deficit without breaking his promises. The Chancellor and PM could study this historical example with profit! (See my article “Treasury Austerity Plans Must Be Ditched; We Need Tax Reform not Tax Rises”).

Robert Lee November 30th 2020

Appendix

The debt ratios referred to in this article are Public Sector Net Debt (PSND) as a % of GDP.  Included in that ratio are loans issued by the BOE’s two Term Funding Schemes (TFS), as well as corporate bonds purchased by the BOE in its Quantitative Easing (QE) programme. These operations have only occurred in recent years, so are a recent addition to the PSND definition. These loans are from the Treasury to the banking sector, with the objective of stimulating banks to provide cheap loans and liquidity to the private sector. The OBR estimates that all £107bn of the first TFS – they have a four year term – will be repaid this year, but about £150bn of new loans will be drawn under the second TFS this year and another £20bn in 2021/22. More BOE purchases of corporate bonds will take place in coming months. These amounts are added to the PSND but will be subtracted in four years’ time when they are repaid. These sums do distort the underlying debt picture so the Chancellor’s use of this figure is a genuine attempt to provide clarity and not fiscal subterfuge!

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About the author

Robert Lee

Robert Lee is an economic consultant and private investor.